Why the Tax Compromise Won't Work

Many on the right, and particularly those who do not truly understand supply-side economics, are propagating the idea that the extension of the Bush tax cuts will bolster investment by business and will trigger a wave of economic activity, thereby helping to pull the U.S. out of its worst economic malaise since Jimmy Carter. This conclusion is wrong.

Moreover, by propagating this pseudo-supply side position, proponents have needlessly made Republicans vulnerable to flanking maneuvers by America's left -- maneuvers that could lead to disastrous consequences for the 2012 elections.

If the Bush tax cuts are extended, the average American will see no change in the size of his paycheck in January. Indeed, the tax cut extension (ceteris paribus) will do nothing but allow the individual's paycheck to remain the same.

Accordingly, without an increase in take-home pay, the individual's propensity to consume will remain largely unchanged. As such, a substantive increase in U.S. retail sales, which still account for nearly 70% of total U.S. GPD, is unlikely to occur until the nation's unemployment situation (now at 9.8%) improves.

Other proponents of the extension have suggested that it will provide small businesses with better clarity about future tax rates -- at least for two years. In turn, this window will promote short-term investments by small business, and this too should bolster U.S. economic activity. Although this argument may seem logical, it fails to consider why firms choose to make investments in the first place.

When an entrepreneur is evaluating whether or not to employ capital into a new project, he is concerned about the free cash flow the project will create. If tax rates increase, by definition, the free cash flows generated by the project are reduced. Consequently, the number of projects the entrepreneur is willing to invest in diminishes.

Any decision to open a new store, to increase a plant's manufacturing capacity, or to expand into a new geographic area typically involves an investment time horizon of much greater than two years. In fact, most of the value implicit in any investment decision stems from a project's terminal value, or the value assigned to the long-term residual cash flows associated with the expansion. As such, when businessmen face prospects for higher taxes and reduced long-term free cash flows, they will shelve marginal projects since mathematically, these projects simply cannot be profitable.

So what are the tax prospects for America's burgeoning entrepreneurs? Not good. In fact, if the Bush cuts are indeed extended, small business owners will face a potential 24% jump in their top marginal tax rate on January 1, 2013, when such rates could jump from 35% to 43.4%.

Of course, this assumes that top marginal rates revert back to the Clinton-era level of 39.6%. And that number leaves out the 3.8% additional Medicare tax imposed on all investment income over $200,000 (individual) or $250,000 (couple), a part of the Obama's health care plan adopted earlier this year. (Apparently, many pundits have forgotten about this gem, since almost no one in the media has been talking about it.)

Given such an onerous tax outlook combined with the immense uncertainty surrounding a plethora of as yet undefined new regulatory burdens from health care, financial regulation, and other federal agency edicts, the environment to start or expand a business is not promising for America's entrepreneurs.

But although an extension of the Bush-era tax cuts will likely not generate increased economic growth, this does not mean a tax cut extension is unwarranted.

In fact, a failure to extend the tax cuts would have deleterious effects on the prospects for U.S. economic growth. In particular, more than half of American households (those who still pay federal income taxes) would experience a decline in their take-home pay simply from the increase in marginal tax rates. Moreover, a failure to extend the Bush tax cuts would significantly reduce the child tax credit (from $1,000 to $500 per child) and would restore the marriage tax penalty. Under such a scenario, already anemic U.S. GDP growth would likely decline between 0.9% and 3.0%. This would certainly set the stage for a double-dip recession.

Given such scenarios, by foolishly suggesting that an extension of the tax cuts is an economic panacea, some Republicans have needlessly cornered themselves: heads, President Obama wins; tails, President Obama wins.

In the event that my analysis is dead wrong and America's economy swarms back to a high rate of GDP growth, President Obama will claim that his actions brought America back from the brink. Of course, many Americans will accept this view without question. In such an environment, it will be difficult to prevent another four years of an Obama regime.

On the other hand, if economic growth remains anemic (as it likely will), Obama will certainly claim, as he has said repeatedly since announcing his candidacy in 2007, that the extension of the Bush tax cuts for the wealthy did nothing to improve the economy and that it only added to the deficit.

If, by the summer of 2012, U.S. GDP growth remains below 2%, if U.S. unemployment remains above 9.0%, and if the federal budget deficit stands at somewhere near $16 or $17 trillion, such claims will be nearly impossible to dismiss. Obama's pincer move on Republican tax-cutters will be nearly complete, and any Republican hope of recapturing the presidency may face checkmate.

By agreeing to the current tax deal on the table -- a deal that does not permanently maintain the marginal tax rates established by the Bush administration -- Republicans may very well have sown the seeds for their own defeat in 2012.

Paul B. Matthews is a Texas-Licensed CPA and a former hedge fund manager.

Many on the right, and particularly those who do not truly understand supply-side economics, are propagating the idea that the extension of the Bush tax cuts will bolster investment by business and will trigger a wave of economic activity, thereby helping to pull the U.S. out of its worst economic malaise since Jimmy Carter. This conclusion is wrong.

Moreover, by propagating this pseudo-supply side position, proponents have needlessly made Republicans vulnerable to flanking maneuvers by America's left -- maneuvers that could lead to disastrous consequences for the 2012 elections.

If the Bush tax cuts are extended, the average American will see no change in the size of his paycheck in January. Indeed, the tax cut extension (ceteris paribus) will do nothing but allow the individual's paycheck to remain the same.

Accordingly, without an increase in take-home pay, the individual's propensity to consume will remain largely unchanged. As such, a substantive increase in U.S. retail sales, which still account for nearly 70% of total U.S. GPD, is unlikely to occur until the nation's unemployment situation (now at 9.8%) improves.

Other proponents of the extension have suggested that it will provide small businesses with better clarity about future tax rates -- at least for two years. In turn, this window will promote short-term investments by small business, and this too should bolster U.S. economic activity. Although this argument may seem logical, it fails to consider why firms choose to make investments in the first place.

When an entrepreneur is evaluating whether or not to employ capital into a new project, he is concerned about the free cash flow the project will create. If tax rates increase, by definition, the free cash flows generated by the project are reduced. Consequently, the number of projects the entrepreneur is willing to invest in diminishes.

Any decision to open a new store, to increase a plant's manufacturing capacity, or to expand into a new geographic area typically involves an investment time horizon of much greater than two years. In fact, most of the value implicit in any investment decision stems from a project's terminal value, or the value assigned to the long-term residual cash flows associated with the expansion. As such, when businessmen face prospects for higher taxes and reduced long-term free cash flows, they will shelve marginal projects since mathematically, these projects simply cannot be profitable.

So what are the tax prospects for America's burgeoning entrepreneurs? Not good. In fact, if the Bush cuts are indeed extended, small business owners will face a potential 24% jump in their top marginal tax rate on January 1, 2013, when such rates could jump from 35% to 43.4%.

Of course, this assumes that top marginal rates revert back to the Clinton-era level of 39.6%. And that number leaves out the 3.8% additional Medicare tax imposed on all investment income over $200,000 (individual) or $250,000 (couple), a part of the Obama's health care plan adopted earlier this year. (Apparently, many pundits have forgotten about this gem, since almost no one in the media has been talking about it.)

Given such an onerous tax outlook combined with the immense uncertainty surrounding a plethora of as yet undefined new regulatory burdens from health care, financial regulation, and other federal agency edicts, the environment to start or expand a business is not promising for America's entrepreneurs.

But although an extension of the Bush-era tax cuts will likely not generate increased economic growth, this does not mean a tax cut extension is unwarranted.

In fact, a failure to extend the tax cuts would have deleterious effects on the prospects for U.S. economic growth. In particular, more than half of American households (those who still pay federal income taxes) would experience a decline in their take-home pay simply from the increase in marginal tax rates. Moreover, a failure to extend the Bush tax cuts would significantly reduce the child tax credit (from $1,000 to $500 per child) and would restore the marriage tax penalty. Under such a scenario, already anemic U.S. GDP growth would likely decline between 0.9% and 3.0%. This would certainly set the stage for a double-dip recession.

Given such scenarios, by foolishly suggesting that an extension of the tax cuts is an economic panacea, some Republicans have needlessly cornered themselves: heads, President Obama wins; tails, President Obama wins.

In the event that my analysis is dead wrong and America's economy swarms back to a high rate of GDP growth, President Obama will claim that his actions brought America back from the brink. Of course, many Americans will accept this view without question. In such an environment, it will be difficult to prevent another four years of an Obama regime.

On the other hand, if economic growth remains anemic (as it likely will), Obama will certainly claim, as he has said repeatedly since announcing his candidacy in 2007, that the extension of the Bush tax cuts for the wealthy did nothing to improve the economy and that it only added to the deficit.

If, by the summer of 2012, U.S. GDP growth remains below 2%, if U.S. unemployment remains above 9.0%, and if the federal budget deficit stands at somewhere near $16 or $17 trillion, such claims will be nearly impossible to dismiss. Obama's pincer move on Republican tax-cutters will be nearly complete, and any Republican hope of recapturing the presidency may face checkmate.

By agreeing to the current tax deal on the table -- a deal that does not permanently maintain the marginal tax rates established by the Bush administration -- Republicans may very well have sown the seeds for their own defeat in 2012.

Paul B. Matthews is a Texas-Licensed CPA and a former hedge fund manager.